Brazil: The Blanket is Short

The government is worried about the exchange rate appreciation and the current account deficit. At the same time, its primary expenses are increasing more than the growth rate of GDP. Apparently the government cannot or is not willing to see the direct relationship between the two facts. In trying to attain the impossible, resources will be wasted which will decrease the productivity of the economy and worsen the fiscal situation.

In the recent years, Federal government primary expenditures have been increasing much faster than the GDP, rising from 15.9% of GDP in 2003 to 17.9% in 2007. This suggests that expenditures increased by 0.5% of GDP every year. According to Cristiano Romero (Valor 5/7) the payroll and the social security expenses should increase by 9% and 8.1% respectively in real terms this year. Besides, although the government estimates signal primary expenses equal to 18.2% of GDP for 2008, more realistic estimates suggest 18.8%, with the Federal Government primary surplus decreasing to 1.1% of GDP, corroborating the expansionist character of fiscal policy.

Given that the excess of spending over income (GDP) equals the current account deficit, an increase in the government expenditures with respect to the GDP necessarily triggers an increase in imports and a decrease in exports, assuming everything else constant. Such movement is even more amplified with an increase in consumption and in private investment, such as has been the case in the last two years. This is so because when the government increases its primary expenses -composed basically of current expenses – beyond the GDP growth, the government tends to foster consumption, pressuring prices and interest rates. In a fixed exchange rate regime, the increase in prices would lead to a real appreciation of the exchange rate. However, in a flexible exchange rate with the Central Bank following its inflation target and therefore reacting to an increase in prices by raising interest rates, the appreciation would mostly be manifested in the exchange rate. The appreciated exchange rate as well as the increase in expenditure boosts imports while exports contract, leading to a current account deficit. In reality, instead of being a problem, free capital movements help in the stabilization process. Capital inflows induce FX appreciation to happen more through the exchange rate than through the price level, avoiding greater changes in the interest rates. With capital controls, inflation and interest rates would necessarily have to be higher to enable the adjustment.

What could change this analysis? In the first place, increasing gains in the terms of trade, with exports becoming more valuable than imports, which is equivalent to an exogenous increase in the GDP. Such a thing indeed happened in the last four years allowing the Central Bank to decrease interest rates in the presence of increasing exports and a current account surplus despite the exchange rate appreciation. In the second place, a high or increasing savings rate,(public or private) to close the gap between income and expenditures (Chinese model). However, the tax burden required to increase public savings may not only be feasible, politically speaking, but would also de detrimental to the productive sector and hence to the GDP. In the past, the equation would close with the increase in prices and the resulting inflationary tax (current situation in Argentina). However, thanks to the political skills of the President such a thing is out of question. There are those who believe that private savings can offset the stimulus on demand induced by the increase in public savings. However, the evidence for Brazil is overwhelmingly against this thesis as private savings have been historically lower than 20% of GDP.

Since it is not advisable to count on a positive external scenario forever, what would be the best set of actions required to revert the current account deficit? As argued by many analysts and displayed above, the best policy is to reduce public expenditures. Such a decrease would be achieved by imposing ceilings on some expenses, inducing social security reform and introducing discipline and efficiency criteria to the government programs. But what should be the obvious, is not in the government’s agenda. Instead of controlling expenditures the government announced a new package with subsidies for exports. At the same time, it tries to curb appreciation with the creation of a sovereign wealth fund, through FX purchases.

The two programs suggest, directly and indirectly, an increase in public expenses and are doomed to fail. Unless the terms of trade keep increasing on a significant basis (in Brazil’s favor) expansionist fiscal policy tends to increase the gap between expenses and domestic production. The gap only closes with external savings, displayed by the current account deficit, with an exchange rate appreciation. Therefore, scarce resources will be directed to useless projects, those with low chances of success, decreasing productivity, raising public debt and the future tax burden. Such a negative dynamic leads to a vicious cycle that will harm growth and will not contribute to fiscal stability.

The economic team wants to curb FX appreciation, increase exports, control imports, create a current account surplus and expand private investment through BNDES subsidies and industrial policy. At the same time, the economic team is silent in the face of greater government expenses. Raising public expenses beyond the GDP is a political option of the government as well of the society. But to think that this can be done without a burden for the economy is wishful thinking. The blanket is short.

Originally published by Valor Economico and translated to English by RGE monitor.